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Fundamental drivers of our current economic problemsUser Forum Topic
Submitted by patientrenter on May 3, 2009 - 10:19am
There's a great article in the Financial Times about one fundamental driver of many of our recent economic problems. It's a bit subtle, so it's not as exciting as "it's all the rich fat bankers' fault", or "it's all the feckless borrowers' fault", or "it's all the fault of the Reublicans/Democrats", but I think it's a key driver, and worthy of a lot more attention from us and our economic and political leaders. http://www.ft.com/cms/s/0/629fe44e-366e-... It may be behind a firewall, so I will excerpt it here. I don't know the fair use rules, so I will try to compensate for any abuse by saying that the author, John Authers, is consistently excellent in his analysis of the financial markets. I subscribe to the FT partly because I appreciate his insights. "The heavy cost of the principal-agent divide Few of us interact directly with financial markets. We have agents to do it for us – brokers, insurers, pension funds and the rest. When we invest or borrow, we are at least one remove from the producer. The person who decides to lend you a mortgage will not bear the risk of your failing to repay it. Instead, that risk is securitised and sold in the form of a bond on the securities market. It makes sense for economic principals to appoint agents to work for them. Most of us have better things to do with our lives than worry about the details of financial products. But the splitting of principal and agent over the past few decades has exacerbated the financial problems that now bedevil us. Most obviously, this affects mortgage lending. The people who authorised “toxic” subprime mortgages in the US did so knowing that they would not have to bear the risk. They had an incentive to lend as much as possible but not to ensure that as much money as possible came back. Meanwhile, the people who ultimately bore the risk, such as big banks and insurers, never had the discipline of looking into the eyes of their borrowers. This might have helped. In its origins, the mortgage industry revolved round debt collectors visiting borrowers in person. Principal-agent problems also apply to investing. For much of stock market history, most shares were held by individuals. Stock brokers, with their own incentives, intruded into buying decisions but there was still a direct connection between shareholders and the companies they owned. As recently as 1980, three-quarters of shares in the US, the world’s biggest stock market, were held by individuals. But that changed with the growth of big institutions, particularly mutual funds in the US. Mutual funds had incentives that diverged from those of the ultimate shareholders. These divergences were slight but they had significant effects. Michael Mauboussin of Legg Mason Investment Management points out that the outperformance of smaller companies in the US, which had persisted for decades, came to an end at about the time that large mutual funds took over as the main investors in the early 1980s. From then until 2000, such institutions roughly doubled their share of the market. Dealing costs are cheaper for big companies, which can also be researched more cheaply. And they looked undervalued. Big mutual funds could not buy enough shares in small companies to have an impact on their portfolio without amassing controlling stakes. And so, Mr Mauboussin points out, the rise of the mutual fund co-existed with the dramatic outperformance of large-cap stocks seen in the chart. Once the internet bubble burst in 2000, the baton passed from mutual funds to unregulated hedge funds. They had fewer assets than mutual funds but they could invest using borrowed money. With leverage cheap for much of this decade, this meant that hedge funds wielded far more buying power each day than their regulated counterparts. By 2007, Mr Mauboussin says, they accounted for about 3 per cent of global equity holdings, but between 30 and 40 per cent of daily trading on Wall Street. Where did they invest? Mostly in smaller stocks. Again, this had much to do with the interests of the hedge funds themselves. They spotted value in small caps and they were small enough to be able to exploit it. And as the chart shows, smaller companies started outperforming once hedge funds took over as the biggest investors. With leverage no longer plentiful, it is now not clear which institutions have the greatest buying power. When it comes to funds that are managed passively, merely tracking an index, the principal-agent problem meets a collective action problem. For individuals, it often makes overwhelming sense to buy an index fund. They have much lower costs than actively managed funds and over time this means they are highly likely to outperform them. But an index fund has no interest in the behaviour of the management of the companies it owns. It will keep holding the company in proportion to its weight in the index regardless of whether managers act in shareholders’ interests. So the growth of indexation has weakened the control shareholders exert over companies’ managements. That in turn allowed managers to behave more and more as though they owned the companies. Chief executives, maybe even more than most of us, tend to be overconfident. This is most true of investment banks, which were once partnerships – where bankers making decisions on what risks to take were also owners. By the time the crisis hit, most investment banks were public companies. The bonus system gave managers an incentive to boost short-term profits. Thus it begins to look, as though the gradual split of principals from agents at all levels of finance has been a big factor in the financial disaster of the past two years. This is among the many problems to be solved as the world’s financial architecture is redesigned. Meanwhile, there is money to be made by those who can identify the most powerful investors and understand the incentives confronting them. john [dot] authers [at] ft [dot] com Copyright The Financial Times Limited"
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This is directly related to my post regarding principal-agent incentive issues from March 16:
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I can't disagree with that. Which reminds me of yet another great quote (this time from Keynes): "Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally."
I think a lot of folks kind of knew in the back of their minds that we COULD be headed for trouble. But, like Chuck Prince - he of "so long as the music's playing we have to dance" fame - there are too many financial jobs that are evaluated and compensated based on short-term performance measures. In other words, it simply pays too well to fail conventionally as things are currently structured.
I like Jim Grant (of Grant's Interest Rate Observer), for example, but Jim would have been fired from running a bank back in 1998 for being unwilling to underwrite loans. (He's unconventional, you see.) This "dancing" issue is a huge problem because (1) everyone presumes they'll be able find a chair when the music stops, and (2) you get fired if you stop dancing too soon.
Anyhow, on a related issue, we obviously need regulatory overhaul with the banks, etc. But what we REALLY need - and what's REALLY at the root of our problems - is a system of misaligned incentives, specifically getting paid in the short-term for instruments that are risky and display a long-term payout.
Mortage brokers getting paid today to underwrite mortgages that would explode later. Lenders getting paid today to underwrite construction loans that would explode later. Traders getting paid today to execute strategies that would explode later. Wall Street securitization desks getting paid today to securitize and sell mortgage securities that would blow up later. Insurance underwriters (think AIG Financial Products unit) getting paid today to underwrite risks that would blow up later.
While we need regulatory changes big time, it's pretty clear to me that these changes will be all for naught if they don't address incentives. If we've learned one thing from this whole debacle it's that, for better or worse, people respond to incentives.
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You can't address principal-agent problems without addressing incentives. They are part and parcel of the same issue.
Incentives were indeed a very important part of the problem, and potentially a part of the solution.
But this article does go beyond incentives. For example, investor principals exert weak control over company management. My favorite recent example of this is BoA and the Countrywide and Merrill acquisitions. I had very carefully chosen BoA as my stock for the "TBTF bank" category, because I thought it was the least tainted by risky home loans. That changed with C'wide and then Merrill, but real BOA investors (not the mutual fund managers supposedly acting in their interest) had no control over those transactions. They should have. Changing the system so that CEOs must get permission from their shareholders for major transactions would help enormously. And there must be a way to get mutual fund managers and other agents to have less influence than ultimate shareholders - real principals.
Institutional money managers have added a certain incremental value to the system, by enabling better diversification for small investors, but they may have subtracted more value in the aggregate by letting public company management become far less answerable to the ultimate investors.
Both are excellent posts. Agree 100% with this being the problem.
But this article does go beyond incentives. For example, investor principals exert weak control over company management. My favorite recent example of this is BoA and the Countrywide and Merrill acquisitions. I had very carefully chosen BoA as my stock for the "TBTF bank" category, because I thought it was the least tainted by risky home loans. That changed with C'wide and then Merrill, but real BOA investors (not the mutual fund managers supposedly acting in their interest) had no control over those transactions. They should have. Changing the system so that CEOs must get permission from their shareholders for major transactions would help enormously. And there must be a way to get mutual fund managers and other agents to have less influence than ultimate shareholders - real principals.
Institutional money managers have added a certain incremental value to the system, by enabling better diversification for small investors, but they may have subtracted more value in the aggregate by letting public company management become far less answerable to the ultimate investors.
I don't disagree with you. But... read your last sentence again in the context of incentives. Part of the problem is that institutional money managers aren't incented to take governance issues seriously. If they were, they certainly would. Most institutional asset managers consider proxy season a nuisance because they have to keep track of proxies, the voting on which doesn't affect how they get compensated. If their compensation was tied into governance issues, they'd take governance more seriously. And again we come back to incentives.
Fair enough, dave, and I would be thrilled if the incentives were changed in an effective way. But at this point, I'd rather just get the agents out of the way. I'd recommend that as a first choice, and if that cannot be made to work then work on the agent incentives. I've seen (and I'm sure you have too) endlessly clever schemes cooked up by agents to compensate themselves regardless of the real long term outcomes for the principals. It's easier to set up your farm away from the swamp than in it.
Dave: If you want to really underscore your point, set it in contrast to what the function of Wall Street is supposed to be: A means or mechanism to efficiently allocate capital where that capital will be most productive.
So how do we explain when all of that capital is egregiously misallocated and over a protracted period of time? I say, look to the compensation packages attached, especially the bonus structures, and it becomes patently obvious.
As odious as certain government regulations are and can be, a nearly complete lack of oversight only emboldened the various players further and deepened the effects of the crisis.
If you want an explanation of what is behind the agent/principal disconnect, look no further than pure, unfettered greed. Greed unhampered by oversight, regulation, ethics or simple common sense. It is completely impossible to have so much collective talent and business acumen so totally miss the obvious signs, unless they were incompetent, willfully ignorant and avariciously greedy.
There was no conscious sense of responsibility that these agents felt for their principals, anymore than the partners at Arthur Andersen Houston felt for the employees at Enron or the citizenry at large (CPA means Certified PUBLIC Accountant and you have an ethical and legal responsibility to act on behalf of not just your clients, but the general public as well).
House in the Hamptons, new Maserati, $2,000/hr escorts, cocaine, Cristal champagne and that custom made French yacht. Why be responsible to your clients when all those toys beckon?
Do we agree that only government can change the agent - principal problem? And that agents have the upper hand in lobbying our govt reps?
I don't see how this can change. The general public howls for foreclosure forebearance, but barely recognizes the agent principal problem. I am usually optimistic, but here I wonder if we've crossed the point of no return. Our pols are pretty much captive to these agents. If this is the case, then there will be ever larger amounts of 'stupid' money that's taken advantage of. I don't like it, but as Authers points out, it does open opportunities to those who choose to take advantage.
PR: Our pols are not only captive to these agents, in many instances, they ARE these agents. Look at Rubin, Paulson, Summers, et al. All of them, at one point or another in their careers, were significant players on The Street.
The MSM have aided and abetted in either obscuring these relationships or mis-reporting the significance of them. Paulson is an excellent example. I can understand why the WSJ hasn't done an in-depth investigative piece on him, but why not the NYTimes or WashPost? Isn't that their job?
Someone mentioned a swamp in an earlier post. I think it's time to drain the damn thing and start over.
The above article is a good read, but I take issue with naming it the "driver of the current economic problems". Rather, the article decribes some of the symptoms of the problem - a problem which was, and continues to be, the Federal Reserve.
No matter how one slices it, the fact is, the Federal Reserve had the constitutional authority to mandate tighter lending guidelines on all lenders. Greenspan could have stopped the ridiculous practices by lenders which gave loans to people with no money down, bad credit scores, etc...But he didn't because the banks which he represents were bringing in record profits during the boom. When Bernanke took over, he was slow to act as well. It wasn't until it was painfully obvious that a severe contraction in the housing market was occurring did Bernanke finally mandate new lending guidelines, but by then it was too late to stop the deflationary contraction. Once Bernanke realized the true extent of the problem on Wall St. he jumped in and paved the way for bailouts for the big banks.
Bob: Greenspan had no reason to stop the practices. He is in this mess up to his eyeballs, as are the politicians and for the simple reason that no one wanted to bell one particular cat: Telling the American people that we can no longer afford to live the way we do.
Wages have been stagnant for 30+ years now. We've been progressively shipping our manufacturing capability overseas for years. We don't make things anymore, we push paper (the so-called "service" industry) and overvalued paper at that. They've been hiding the facts for years now and no one wanted to be the one to tell us this party's over and the bill is due. So Greenspan presided over nearly two decades of feckless and reckless monetary policy and the pols not only loosened the regulatory leash, they threw it away completely.
Meanwhile, ever larger debt creation at the personal, commercial and national level gave the appearance of "wealth" and "prosperity" where none really existed, but as long as we had our McMansions, Hummers, plasma TVs and lattes, who gave a shit, right?
You are correct, and the Feds continue to do so even now. In fact, current spending is so far beyond control that the only way to solve the debt problem in future years will be to devalue the dollar, raise taxes, and cut entitlement programs. Of course, this will cause inflation, and put a real drag on the economy....but what do the banks care ? They've got an unlimited supply of bailout money as long as Obama is in office.
Lol! What incentive problem? Oh, yeah. I'm sorry, I got lost in the daydream painted by your words. Was I complaining about that? It's disgusting. BTW, if I were on the dark side, where could I sign up? I'm doing a paper on it...
I don't see how this can change. The general public howls for foreclosure forebearance, but barely recognizes the agent principal problem. I am usually optimistic, but here I wonder if we've crossed the point of no return. Our pols are pretty much captive to these agents. If this is the case, then there will be ever larger amounts of 'stupid' money that's taken advantage of. I don't like it, but as Authers points out, it does open opportunities to those who choose to take advantage.
I don't think the government can change the principal-agent problem unless shareholders (the principals) are willing to do their part (that is, pay attention and vote accordingly) as well. But I think the regulatory structure can encourage much better behavior, that's for sure. And help keep losses from moving to the public at large.
So how do we explain when all of that capital is egregiously misallocated and over a protracted period of time? I say, look to the compensation packages attached, especially the bonus structures, and it becomes patently obvious.
As odious as certain government regulations are and can be, a nearly complete lack of oversight only emboldened the various players further and deepened the effects of the crisis.
If you want an explanation of what is behind the agent/principal disconnect, look no further than pure, unfettered greed. Greed unhampered by oversight, regulation, ethics or simple common sense. It is completely impossible to have so much collective talent and business acumen so totally miss the obvious signs, unless they were incompetent, willfully ignorant and avariciously greedy.
There was no conscious sense of responsibility that these agents felt for their principals, anymore than the partners at Arthur Andersen Houston felt for the employees at Enron or the citizenry at large (CPA means Certified PUBLIC Accountant and you have an ethical and legal responsibility to act on behalf of not just your clients, but the general public as well).
House in the Hamptons, new Maserati, $2,000/hr escorts, cocaine, Cristal champagne and that custom made French yacht. Why be responsible to your clients when all those toys beckon?
Agreed, however... recall that it generally takes two to tango. There were a lot of supposedly sophisticated institutions buying a lot of the dreck that Wall Street was selling. It wasn't just wolves selling to the Little Red Riding Hoods.
Also, I know that there were a lot of frictional costs "lost" to Wall Street over the last decade. But I think some of this is overstated. A couple of examples. I saw some article recently stating that profits from the financial industry had increased by 2 or 3 times above the norm as a percentage of GDP. Yes, a lot of this came from "friction" (asset management fees, investment banking fees, etc.), but the lion's share came from... interest received on much higher debt levels. About 75% of banking industry revenue comes from interest income, plain and simple. So as debt rises as a percentage of GDP - as it has, big time - then financial industry revenues as a percentage of GDP are going to rise... regardless of frictional fees. So, yes, all of the fee stuff is too high... but that stuff is a drop in the bucket compared to interest income off of higher debt balances. (Which is kind of scary as to what it suggests for where debt levels are. But we Piggs are already aware of this.)
Where friction is concerned I'll use the equity mutual fund industry as an example. The average index fund charges about 20 bps in fees. I think the average active equity fund/investment manager charges about 100 bps (some are higher, obviously). The index fund fees are about as low as they can go. The active funds - forgetting about performance - should probably be at about 60 bps (and arguably less) to generate an economic profit for the manager. So, maybe there's 50-60 bps of totally wasteful friction in the "traditional" investment management industry (that is, ex-hedge funds, private equity and index funds). If long LONG term returns on stocks are about 8.5%, that 50 bps is about 6% of the total return. Not good, don't get me wrong. But not a disaster. Recall that in 1999, after a 17-year run in which the S&P 500 returned 19% annually, only cranks like John Bogle (I use the term "crank" in its most affectionate sense) were complaining about mutual fund fees.
Yes, investment banking fees are all too high, but again... these fees are small in the whole scheme of things. Although they seem absurd relative to the small group of folks that share in the proceeds.
But a lot of these fees are simply a result of folks "buying the dream." Why do folks pay active managers high fees? They buy the dream that these folks can beat the market. Same goes for hedge funds and private equity funds. Same goes for brokerage fees generated through trading on behalf of clients. Why do companies pay eggregious investment banking fees? Because shareholders allow management to engage in silly transactions on which such fees are levied. And so on and so forth.
The bottom line is that there should be LESS: trading, M&A, offerings, active management, etc. There should be MORE operating and long-term investing. But that stuff's not fun. It's not sexy. Which is why there will always be a ton of friction for Wall Street to live off of. People love the dream. Hope springs eternal. And they'll gladly pay for it.
The shift of manufacturing to other countries is what I see as the biggest problem. How can a country flourish if they do not make "stuff"? We have become the world's buyers, we buy a majority of our stuff, sending our jobs and money to other countries.
We tried the whole bubble mania thing and simply selling each other houses for higher and higher prices. That's not sustainable work. Making the shit you use on a day to day basis, is sustainable work.
I have been lambasted for supporting US automakers many times recently and not just on this board.
I look at US jobs as something we all should band together and fight for. Especially well paying manufacturing jobs with good benefits. I think its odd that Europeans will block roads and protest to keep US automaker factories open in their countries, yet so many of us here seem to want to see them fail.
By the time most people "get it" it will be too late. I think we should bring fairness into "free" trade even if it means risking a trade war to bring manufacturing back to the states. Better a trade war than a military war to get us out of this mess.
"May 4 (Bloomberg) -- Post-recession America may be saddled with high unemployment even after good times finally return.
Hundreds of thousands of jobs have vanished forever in industries such as auto manufacturing and financial services. Millions of people who were fired or laid off will find it harder to get hired again and for years may have to accept lower earnings than they enjoyed before the slump."
http://www.bloomberg.com/apps/news?pid=2...
It's really all about innovation and productivity. First, you invent it, then you make it. They both have rewards and costs. But they are clear drivers for economic growth. We've abdicated production from the US for several decades now. This has caused growth in those countries that do the production and now they are going into the innovation phase themselves. Thus creating more competition for the US and driving down wages for the creative class that tends to innovate. This has been going on for our production class for quite some time. It's a kind of global leveling.
I believe the horse has long left the barn on this one.
This is all nice, but I believe the ratings agencies are the root of the problem. Without overrated securities, none of this would have happened. The bad ratings created more demand for mortgages, which forced lenders to rely more on their distributed network. The distributed network of brokers emerged because of the bad ratings, not the other way around.
Good point, we need some perp walks on that front.
Spend some time and read the OCC and the FedRes job descriptions, seriously.
John Dugan, head of OCC
2005 speech:
Dugan recognizes, for example, that the industry is at the top of the credit cycle, and that risks are lurking that both banks and their regulators must stay on top of. "We will be watching--and watching closely--and we will not hesitate to act," he said in an early speech to bankers.
Dugan believes both banks and regulators learned a great deal from past crises, and he sees a big part of his job being to make sure the industry doesn't return to a time of widespread failures.
John Dugan comes to the OCC job with credentials as substantial as predecessor Jerry Hawke. He is a repository of a great deal of modern banking history that he not only lived through, but had a hand in shaping.
"I suppose the more risks you have, the more complicated risk management can become," says Dugan. "But we wouldn't want to be in a situation where we were ignoring something that could be a substantial risk to institutions."
Dugan has been knee deep in every banking problems since the S & L, an expert on regulation and operating procedures and a Harvard lawyer. Of course, his solution is to create another federal agency.
The Fed and OCC are in charge of monitoring these things. That is there job.
Interesting thing about the OCC is it gets paid by the banks to regulate. It does not take appropriations from congress.
Interesting thing about the OCC is it gets paid by the banks to regulate. It does not take appropriations from congress.
I believe only the Fed and perhaps the Office of Thrift Supervision get any money from Congress. The FDIC folks are paid via the fees they levy on bank deposits. The state regulators are paid out of state coffers. As you point out, the OCC is paid out of fees levied on the banks... which leaves the Fed and OTS.
Rt 66, would you say that it's best to only buy things that the people closest to you make? Should that be people in your township only? Or just your family? Or maybe just you?
Why is it best not to buy things from people in other countries if you like them and they are offering them to you at a good price?
We don't eat potatoes in our house. All the potatoes come from Idaho! Buy Californian!
China just bought a bunch of gold from the IMF too. Something is going on? IMF proposed the world currency reserve recently that China endorsed. Methinks some back room deals are going on...
“We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.”
- Chinese premier Wen Jiabao 12th March 2009
http://www.ft.com/cms/s/2f842dec-38d8-11...?
http://www.google.com/hostednews/afp/art...
Why is it best not to buy things from people in other countries if you like them and they are offering them to you at a good price?
If my local manufacturer provided a higher quality product, and was a net benefit to my community because of the jobs it provided to our local residents, I would definitely be willing to pay more in order to support what I believe is right -- treating employees fairly; paying a livable, middle-class wage; abiding by regulations that ensured our environment wasn't being polluted, etc.
Funny anecdote:
When my mother passed away in 2007, I sold her vacuum cleaner at an estate sale. It was the same vacuum cleaner she had for about forty years, and still outperformed new cleaners. She was a neat-freak, and used it often. The same can be said of old TVs, stereos, etc. Try that with today's plastic crap from overseas.
We used to make GOOD QUALITY products, and even though you might have paid more for it, it could be fixed in a repair shop, if necessary, and would outlast by 4 or 5 times++ the stuff we buy from Wal-Mart today. Our workers were able to live comfortable, middle-class lifestyles, and had job security and medical benefits -- which were somehow much more affordable than they are now.
We used fewer resources and created less environmental destruction because we weren't disposing of our "obsolete" junk every couple of years.
We've been lied to about the benefits of globalization. True, it might benefit developing nations, but it does NOT benefit us.